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Corporations

Prof. Gary Chodorow Beijing Foreign Studies University 2005-06 Semester II

Class 1--Introduction

A. What is a Corp?

B. Players C. Basic Attributes of a Corp D. Theory of the Firm

A. What is a corp?

1. Legal entity 2. Any size 3. Investment vehicle to pool $ & management.

4. Corp (or any business association) exists because command & control is cheaper than bargaining on the market.

B. Players

1. Shareholders 2. Managers—directors & officers 3. Lenders 4. Customers 5. Persons injured by the business 6. Government

C. Basic Attributes of a Corp

Suppose you were asked to invest $1000 in a company. What questions would you ask (besides about the product or service)?

1. How long does the investment last? Separate, perpetual existence.

2. Who manages the investment? Centralized management.

3. What is the return on investment? Ownership interests tied to residual earnings & assets.

4. How can investors get out? Transferability of ownership’s interests.

5. What are investors’ responsibilities to others? Limited liability for all participants.

1. How long does the investment last?

Separate, perpetual existence.

• Perpetual: Persons who contribute $ & labor may change, but corp doesn’t.

• Separate: Corp not individuals owns the business’ assets and is liable for the debts.

2. Who manages the investment?

Centralized management.

a. Board of Directors manages the corp. It often delegates power to officers.

b. Directors & officers have fiduciary duties to corp.

c. SHs have only limited role in management.

3. What is the return on investment? Ownership interests tied to residual earnings & assets.

Hierarchy of rights to business earnings: i.

Creditors (e.g., bank lenders, bond holders, employees) get return based on k.

ii. Only then do SHs get dividends as declared by board.

b. Similarly, if business dissolves, creditors’ claims have priority over SHs’.

4. How can investors get out? Transferability of ownership’s interests.

• Shares are freely transferable—SHs realize value of investment thru sale.

5. What are investors’ responsibilities to others? Limited liability for all participants.

a. Corp liable for own obligations.

b. Corp insiders (dirs, ofcrs, SHs, lenders) not personally liable to outsiders on corp’s obligations (unless “veil pierced”).

c. Outsiders (k creditors and tort victims) bear risk of corp insolvency.

D. Theory of the Firm

SHs & mgrs have conflicting interests which may prevent corp from maximizing earnings: • Mgrs: – Lazy.

– Want huge “perqs.” – Reluctant to make changes that threaten job security.

• SHs: – Refuse to reinvest earnings in business.

– Want mngrs to take risks for high returns.

– Want intrusive control powers.

Corp law tries to minimize conflicts. Two views of how…

•

Traditionalists

--See corp as “control device”: In public corps, active mgrs may dominate SHs. Purpose of corp law is to control mgr opportunism (e.g., increase SH voting power, require mgrs to disclose info to SHs, strong fiduciary protection).

•

Contractarians

--See corp as a “nexus of ks” (voluntary relations among constituents bound together by ks, statutes, market constraints). These factors control mgr opportunism. Purpose of corp law is to enforce their bargains.

Traditionalists: Contractarians:

1. Mgrs use “control” to exploit SHs & other constituets: (a) SHs dispersed, so it’s hard for them to organize; (b) it’s not cost effective for SH Mgrs can’t exploit SHs because market constraints align their interests with SHs. (E.g., bad managers will be unsuccessful on the job with diversified investments to spend a lot of time of corp’s concerns.

market). Also, SHs can’t be easily exploited by mgrs because can sell if mgr abuses cause share price to drop.

Traditionalists:

2. SHs can be exploited because they are unsophisticated or uninformed.

Contractarians:

50% of shares owned by sophisticated institutions. They become informed through firms like Institutional Shareholder Services and Investors Responsibility Research Center. Thus, SHs can’t be exploited.

Institutional Shareholder Services & Investors Responsibility Research Center

• Provide proxy voting & corporate governance services.

• Serve institutional investors by analyzing proxies & issuing informed research & objective vote recommendations.

• Premise is that good corp governance ultimately results in increased SH value, so SHs need to participate in corp governance.

Traditionalists: Contractarians:

3. Corp law should mandate rules to promote fairness & efficiency. Corp law should seek to infer & enforce the parties’ bargain, whether explicit or implicit.

Traditionalists:

4. Js should actively enforce mgrs’ fiduciary duties to SHs.

Contractarians:

Js should interfere only cautiously. Demanding too much accountability from mgrs reduces the discretion they need to successfully manage the business.

Hypothetical

A bank (corp) loses money because its directors approve construction loans in reliance on overly optimistic projections about the real estate market. (The borrowers default on the loans, bank forecloses, getting title to real estate worth less than the amount of the loans.) Assume the directors’ mistake was honest & they took reasonable steps to become informed about the projected real estate market.

Question: Are the directors liable to the SHs for the loss? What are the policies behind your answer?

Class 2--Introduction

A. Sources of Corp Law B. Choice of Form C. Incorporation & Organization D. Choice of Law E. Ultra Vires & Corp Social Responsibility

A. Sources of Corp Law

1. State corp statutes 2. State common law 3. Federal statutes 4. Federal regulations 5. Stock market rules 6. American Law Institute Principles of Corporate Governance

State Corporation Statutes

Regulate how to incorporate; structure of board, SH rights; governance powers of SHs, dirs, ofcrs….

38 states have enacted states ABA Model Business Corporation Act, but some have not (e.g., DE, NY, CA).

Some terms are mandatory (e.g., dirs must be elected annually), but some terms are default rules that apply unless the parties choose different terms (straight v. cumulative voting).

State Common Law

a. Common law interpretations of state corporation statute.

b. Common law caselaw creating legal principles (e.g., fiduciary duties, shareholder derivative suit)

Federal Statutes

Securities Act of 1933: regulates raising capital in public markets, whether by selling stock or taking on debt.

Securities and Exchange Act of 1934: Corps whose stock is publicly traded are subject to periodic reporting requirements, proxy rules, securities fraud rules, & other rules.

Sarbanes-Oxley Act of 2002: rules about board’s audit committee, hiring audit firms to do nonaudit work for the company, rules regarding conduct of corporate/securities lawyers.

Digression: Enron Scandal

• Enron was 7th largest US corp, engaged in energy & trading.

• Committed financial accounting fraud in order to increase share value: – Transactions with supposedly independent entities to make its financial statements look better—remove liabilities & increase revenues. In fact, these weren’t independent entities but companies controlled by Enron executives.

– Mgrs profited by getting higher salaries, bonuses, stock options.

• In 2001, upon discovery of fraud, Enron went bankrupt, wiping out SH investments & employee pensions that invested in Enron shares.

• Arthur Anderson (independent accountant) criminally indicted and folded.

Federal Regulations

• Congress established the Securities and Exchange Commission (SEC) in 1934 to enforce the newly-passed securities laws, to promote stability in the markets and, most importantly, to protect investors. • SEC rules are codified in title 17 of the Code of Federal Regulations.

Stock Market Rules

A US stock exchange (NYSE, NASDAQ, AMEX) must register with SEC. SEC requires exchange have a body of rules for its members. E.g., a majority of the dirs of each member corp must be independent.

ALI Principles of Corporate Governance

• Project to describe and unify the basic rules for corp governance & structure.

• Not as well received as the ALI restatements in other areas of law. Courts mixed on how persuasive this authority is.

B. Choice of Form

Q: Oliver & Irene plan to open a flower shop. Matt will run the shop. Ingrid will invest the money.

What business form should they use?

Basic Information

Sole Proprietorship A single individual owns business’ assets.

That person is liable for any business debts. No formal requirements to form or operate this business.

Business profit or loss shown on personal tax return.

General Partnership: Partners share mgt & profits. Each is fully liable for GP’s debts. GP generally seen as an aggregate of its owners, not a separate legal entity like a corp.

Partnerships are prevalent in service industries (e.g., law, accounting, medicine) where trust must exist among participants and capital needs are not great.

Law: Revised Uniform Partnership Act 1997

Limited Partnership Must be at least 1 general partner who runs business & is fully liable for LP ’ s debts.

Limited partners provide capital & are liable only to extent of their investment (provided they don ’ t run the business).

Law: Revised Uniform Limited Partnership Act 1985

Limited Liability Company Hybrid between corp & partnership. Like partnership, members of LLC provide capital & mng the business. Like corp, members are not personally liable for debts of the LLC.

Law: All states have an LLC act.

Detailed Comparison of Business Forms

See Handout

Grigg has a sole proprietorship landscaping business. He has done most work himself & is the sole investor. Now, he wants to hire employees & purchase equipment. Sister is willing to invest, but she wants assurance she won’t have to pay any more than what she invests.

a. Assume Sister invests on the “understanding” that she will share in profits, will help Brigg run business, & will not be liable beyond her investment. Is her liability exposure limited?

b. What forms of business organization might accommodate Pearl’s multiple wishes? Is this for sure?

c.For Pearl, what is the difference between being a LP limited partner, LLC member, or corp SH?

C. Incorporation & Organization

“Incorporator” must: 1. Prepare, sign, file articles of incorporation.

2. Hold initial SH/dirs’ meeting.

3. Open a bank account for corp.

4. Issue shares.

Articles of Incorporation

1. Must include (MBCA § 2.02): a. Corp name b. # of shares corp authorized to issue in each “class” with description of privileges & limits on each class.

c. Name & address of agent for service of process.

d. Name & address of each incorporator.

2. Articles meeting these requirements & accompanied by incorporation fee must be accepted by Secretary of State.

D. Choice of Law

“Internal affairs doctrine”: a. Law of the state of incorp governs most

intra

corp relationships.

• • • • b. Policy: Corp should not subject to conflicting state laws.

• • c. In other states, corp may still need to: 1. pay local taxes 2. submit to jurisdiction for lit 3. file as a foreign corp if doing

intrastate

business (not interstate business like mail order company)

50% of Fortune 500; 40% of corps traded on NYSE choose DE. Why?

Where to file the articles of incorp?

Local corp usually chooses state of PPB to avoid paying extra taxes & fees in another state.

Local corp may like to have local corp counsel, whereas national corp may like DE’s expert counsel, law, judiciary—more predictable.

Incorporators may choose state favoring management over SHs (e.g., fiduciary duties, antitakeover statutes).

E. Ultra Vires & Corp Social Responsibility

Ultra Vires = common law doctrine relating to the effect of corp acts that exceed the powers or stated purposes of a corp.

In the 19 th century, corps power was mistrusted so articles had to state limited purposes. Any action beyond those purposes was “ultra vires.”

3. Today, corps can be established for any lawful purpose, so ultra vires doctrine has diminished in importance.

4. Still, some corporate philanthropy & provision of benefits to others besides SHs may be challenged as ultra vires. E.g.,

A.P. Smith Mfg. Co. v. Barlow

(N.J. 1953).

Class 3

• Chapter 2. Promoters’ Liability & Defective Incorp • Chapter 3.Piercing the Corporate Veil—The Limited Liability Debate

Chapter 2. Promoters’ Liability & Defective Incorporation

§ 2.02. Promoters’ Liability on Preincorp Ks § 2.03. Defective Incorporation

2.02. Promoters’ Liability on Preincorp Ks

1. Promoter = ? 2. First issue: Is the promoter liable for acts taken on behalf of the corp to be formed?

What is the parties’ intent?

1. Revocable offer by other party that can be accepted by corp after formed. 2. Irrevocable offer by other party for a limited time. Consideration is promoter’s promise to organize the corp & use best efforts to accept it to accept offer.

3. Present k by which promoter is bound, but with an agreement that his liability terminates if corp is formed & adopts k.

4. Present k on which, even though corp becomes a party, promoter remains liable either primarily or as surety.

1. Traditional (strict) rule on promoter’s liability

a. RKO-Stanley Warner Theaters, Inc. v. Graziano

(Pa. 1976)

b. Goodman v. Darden

(Wa. 1983) 2. Cases considering surrounding facts and circumstances.

a. Sherwood v. Alexander

(Or. 1974)

b. Quaker Hill, Inc. v. Parr

(Co. 1961).

Second issue: Is the corp liable for promoter’s ks? Only if “adopts” k … 1. Explicitly 2. Implicitly 3. Acquiescence.

Bascomb plans a business offering carriage rides. He hasn’t incorporated yet, but he plans to. He signs k with Antiques-R-Us to buy 10 carriages. He signs as “agent for ClassicRides, Inc., a corporation to be formed which will become a party to this contract.” The k calls for installment payments over 12 months.

a. Before ClassicRides is incorporated, Bascomb takes delivery of the carriages. When the first installment comes due, is Bascomb liable on the k?

b. After ClassicRides is incorporated, Bascomb continues to use the carriages in the business. When Antiques-R-Us is not paid, is Bascomb liable?

c. After ClassicRides is incorporated & has paid 4 installments, Bascomb sells his shares to Carolyn, who repudiates the Antiques-R-Us k. Is ClassicRides liable?

d. After ClassicRides is incorporated, Bascomb wants to make clear there is a novation. Antiques-R Us’ manager agrees to tear up the original k and sign a new one with ClassicRides. Bascomb signs as follows: /s/ J.S. Bascomb President, ClassicRides, Inc.

Does this signature accomplish Bascomb’s purpose?

2.03. Defective Incorporation

• The Problem: – Birth: L forgets to file articles; or SOS returns articles for failure to pay proper fee.

– Death: Corp fails to file annual reports or pay annual franchise fee.

– Parties believe valid corp exists.

– Are the parties personally liable?

Common law defenses to personal liability for defective incorporation: 1. De facto corp: (a) The firm could have incorp’d; (b) Def made good faith attempt to incorp; &and (c) Def actually used corp powers he believed he possessed. E.g.:

Cantor v. Sunshine Greenery, Inc.

(N.J. Super. 1979).

2. Corp by Estoppel Defense: If (a) Insiders believe they’re incorporated; & (b) Outsiders dealt w/business as if it were a corp, then outsiders estopped from later seeking personal liability on defective incorp theory.

E.g.:

Cranson v. IBM

(Md. 1964)

MBCA approach: • § 2.03: Corp born when SOS issues certificate of incorp.

• § 2.04: Insiders acting on behalf of corp with knowledge there was no incorporation are personally liable.

• Cts split: – MBCA § 2.03 implies limited liability only if certificate of incorp actually issued.

Robertson v. Levy

(D.C. Cir. 1964) – MBCA § 2.04 implies no personal liability if def didn’t act (i.e., passive SH) or had no knowledge there was no incorp, so common law defenses still available.

MBCA § 14.22 on corps that have been dissolved for failure to file annual report or franchise tax: If reinstated within 2 years, no personal liability.

1. Bascomb enters into a contract with Versacci to purchase uniforms for ClassicRides’ carriage drivers. He signs the k as president of ClassicRides. When Versacci delivers the uniforms, ClassicRides does not pay. Versacci sues Bascomb on the k.

a. Suppose Bascomb mailed articles of incorporation for ClassicRides to the secretary of state 2 weeks before signing the k but the articles were lost in the mail. How might Bascomb argue he is not liable on the k?

b. Suppose Bascomb asked his lawyer to create the ClassicRides corp but the lawyer forgot to file the articles. As Bascomb’s new attorney, how would you argue that he is not liable on the k?

Chapter 3. Piercing the Corp Veil

• §3.02. The Limited Liability Debate • §3.02 Grounds for Piercing the Corp Veil • …

§3.02. The Limited Liability Debate

Advantages of Limited Liability:

Disadvantages of Limited Liability:

Class 4—Piercing the Corp Veil (cont’d)

• Procedure for Piercing • Factors Considered in Piercing • Equitable Subordination

Procedures for Piercing

1. Basis for corp liability.

2. If corp has insufficient assets to satisfy a prospective judgment, argue for piercing.

3. When veil pierced, all* SHs are personally liable (not directors or officers of corp.— although these groups overlap).

* A few cases to contrary (p.59, n.73).

Factors Considered in Piercing

How was corp form misused?

Commingle corp & individual assets/affairs.

Corp formalities ignored.

Inadequate capitalization or purposeful insolvency.

Evasion of a K or Statute or Use of a Corp to Work a Fraud.

Who is liable if veil pierced?

Another corp in same family?

Individual actively involved in bus?

Passive SH?

Is pl an involuntary creditor?

1. How Was Corp Form Misused?

Evasion of a K or Statute or Use of a Corp to Work a Fraud a.

Elements: i.

Purpose of corp was

solely

to evade a k or statute; or ii. Use of s corp

solely

to work a fraud.

Commingle (aka intermix) corp & individual assets/affairs.

ii.

Elements: Mixture of corp & SH’s assets/affairs (At expense of corp) or (to benefit other) b.

E.g.: – Loan to SH with no interest or without documentation.

– Using corp bank account to pay personal expenses.

Policy: SH’s interference in corp may reduce its assets available to creditor.

Corp formalities ignored.

a. E.g.: – No documentation for loans & other transactions.

– Failure to issue stock certificates, hold meetings, elect officers.

b. Policy: Ignoring corp informalities is indirect evidence of commingling of affairs that harm corp’s creditworthiness.

Inadequate capitalization or purposeful insolvency.

Inadequate capitalization. Elements: At time corp formed ii. Trifling or illusory capital (equity, loans, insurance) iii. To pay for foreseeable debts.

Caselaw mixed on whether this single factor alone is enough to pierce.

Policy: If inadequate capitalization at time of formation, purpose of incorp may have been to serve as an instrument of fraud.

Purposeful Insolvency 1. Elements: i.

SH siphons off corp assets.

2. E.g.:

DeWitt Truck Brokers v. W. Ray Flemming Fruit Co.

(4 th Cir. 1976) (not in book) 3. Policy:

2. Who Is Liable if Veil Pierced?

Another Corp in Same Family: 1.

Enterprise liability considers following factors: Multiple corps under common ownership.

(i) Sub is “mere instrumentality” (exists merely to carry out parent’s orders), or (ii) there is otherwise intermixture of assets/affairs, or (iii) similar businesses are artificially separated to isolate risk of loss.

Pl not a voluntary creditor aware of the separate business entities. Policy: Enterprise’s interference in corp may reduce its assets available to creditor; also, creditor may be misled about corp’s creditworthiness (e.g., not know profits siphoned off to parent).

Individual SHs: • Individual SHs of CHC sometimes found liable.

• No reported case has involved finding passive SHs of PHC liable because too many innocent SHs become potentially liable.

3. Is Pl an Involuntary Creditor?

1. Voluntary creditors can anticipate corp’s “no recourse” structure & k for personal guarantees, higher prices, or assurances on how business will be conducted. 2. Involuntary creditors (tort victims and retail customers) can’t protect selves as easily.

EXERCISES

In 2001, Don formed a clock repair business, Timend Inc. The corp made a 10-year lease with Realty for its store. For a few years, Timend did pretty well. Don drew a salary about equal to his net earnings. He kept careful records of receipts & payments. But he didn’t observe corp formalities: no SH or dir’s meetings; no corp resolution authorizing his salary; no dividends. Last year, Timend began to struggle, & Don’s salary shrank.

a. Don closes the shop, telling Realty he can no longer make lease payments. Can Realty pierce the veil to recover from Don personally?

b. Don had set up a separate corp, Heirloom Timepieces, to repair clocks valued at more than $5,000. Don used separate invoice forms for Heirloom, which subcontracted its work to Timend. Can Patrick, an Heirloom customer, look to Timend’s assets for recovery?

Rupert incorporates Exquisite Timepieces Ltd., a mail order business that sells watches through TV commercials. He capitalizes the business enough to buy TV time and an initial stock of watches. ETL gets off to a good start. Rupert receives a generous salary equal to 80% of gross receipts. He keeps meticulous records and observes corp formalities carefully. As new orders come in, he fills prior orders. After a while, customer orders go unfilled. Soon there is a large backlog of unfilled orders.

a. Rupert writes expectant customers, “ETL has experienced a cash flow crisis and cannot fill your order.” Can customers pierce the veil?

Example: CERCLA

• Under CERCLA, “owner” & “operator” of hazardous waste site is made liable for “response costs” (cleanup).

• Liability will extend to another member of the corp family under same rules for piercing the veil.

United States v. Best Foods

(U.S. 1998) • F: Parent sent its own employees to participate in subsidiary’s ordinary operating decisions related to toxic waste.

• H: Parent is liable as “operator”.

• R: Parent directly controlling sub. Goes beyond role of SH (eg, electing directors and officers, monitoring corp’s performance).

Equitable Subordination (aka Deep Rock Doctrine)

In a bankruptcy, SHs don’t get distribution until after creditors—go to “end of line.” If a SH is also a creditor (e.g., loan to corp or employee of corp drawing salary), should SH still go to “end of line”? Yes, under same test as veil piercing.

Getting subordinated (losing contribution to corp) not as bad as piercing corp to find personal liability (lose personal assets too).

Example from p.53

Facts: Corp goes bankrupt with $100,000 assets and $500,000 liabilities (debts to SHs of $300,000 and outside creditors of $200,000).

If SHs participate with creditors, they collect 20% of debt ($100,000/$500,000).

If SHs subordinated, outside creditors collect 50% of debt ($100,000/$200,000).

If veil pierced, outside creditors collect 100% of debt ($100,000 from corp & $100,000 of SHs personal assets).

Class 5—Financing the Corp

• Introduction • Securities: Debt, Common Shares, Preferred Shares • Leveraging & Capital Structure • Legal Capital Rules: Preemptive Rights, Par Value, Dividends & Repurchases of Shares • Valuation: Liquidation, Book Value, Earnings Approach

§ 4.01 Introduction

Methods of Raising Capital: 1.

Borrowing—Corp owes debt to creditors. Corp must pay principal & interest according to loan schedule. Interest on debt is tax deductible to corp.

Investment—SHs hold equity in the corp. Corp needn’t return investment unless corp dissolves or dirs offer repurchase shares. Dirs may pay “dividend” out of corp profits. SHs may be able to sell their shares.

Retained Earnings—Profits held by the corp & not paid out in dividends to the SHs.

SH Rights v. Creditor Rights: 1. Creditors have priority over SHs, so corp can’t pay dividends unless its debt payments are up-to-date.

2. If debt payments not up-to-date, creditor may force corp into bankruptcy. In bankruptcy, creditors receive their principal before SHs get anything.

In summary, SHs have greater risk but also potential for greater return.

§ 4.02 Securities

Security = Transferable “instrument” representing financial value issued by corp to raise capital.

Types of security issued by PHCs: Debt, common shares, preferred shares.

Attributes of security: Risk of loss b.

Power to control the business Return

Debt

– – Debt security = Obligation to pay specific sum at future date & usually to pay interest (% of bond’s face amount) at specified times in interim.

Risk of loss: Generally less risky than equity because debt has priority. Risk depends on whether: Bonds = secured by specific assets, which in case of default, must be auctioned off to pay debt. (less risky) Debentures = unsecured debt, so holders have a general claim to assets with other unsecured creditors. (more risky)

3. Power to control the business: If debt is sold to public, k is called “indenture.” Trustee selected to represent the interests of the public debt holders. Trustee will exercise any power to control the business specified in k.

4. Return: Generally don’t share in profits if business successful.

Common Shares

Common share = claim to receive share of residual income & assets of the corp after all other claims have been satisfied.

Risk of loss: Lower priority than other securities.

Power to control business: Vote to elect board.

• • • Return: Value of shares grows if corp profitable.

May receive dividends.

So, greater potential for return than other securities.

Preferred Shares

Preferred shares = Shares authorized by articles with specified rights, usually that they receive a “preference” over common SHs if (a) dirs pay a dividend or (b) corp assets distributed upon liquidation.

Risk of loss: Priority in between creditors & common SHs.

Power to control business: Usually no voting rights.

Return: Usually, just paid dividends of a fixed amount of $ per share each quarter, so don’t get increased return if corp successful.

Preferred Share Debt 1. Creation of new class or issue Amend articles 2. Maturity date No Resolution by dirs Yes 3. Right to vote Usually no 4. Treatment on balance sheet Equity Usually no Debt

Preferred Share Debt 5. Interim payments Dividend 6.Interim payment amount Fixed (usually) 7. Omission of interim payment Carries over if cumulative 8. Tax effect on corp of interim payment Not deductible Interest Fixed (usually) Default Yes tax deductible

§ 4.03 Leveraging & Capital Structure

1. Corps usually finance operations w/both debt & equity.

2. “Leverage” = debt/equity ratio.

3. As leverage increases – if business successful, SHs’ ROI as a % of investment increases.

– If business poor, risk of bankruptcy increases

A B C Equity Debt 1 st -Yr Earnings Pay Creditors ROI Leverage $100 $0 $20 (20%) $40 $100 $60 @ 10% interest for 1 year “ “ $32 (20%) $0 $66 “ $20 (20%) 0 $14 (35%) 150% $26 (26%) 60%

§ 4.04 Legal Capital Rules

• • • A few terms… Authorized shares: Articles must state the number of shares that the dirs are authorized to issue in each class.

Outstanding shares: Shares that have actually been issued by the dirs.

Treasury shares: Shares repurchased by dirs from SHs.

Preemptive Rights

SH’s ownership interest depends on number of shares actually issued, not those merely authorized to be issued.

1000 shares authorized 400 shares issued X owns 100 shares = 25% interest in corp.

If corp then issues the remaining 600 shares to others, X’s ownership interest has decreased.

1000 shares authorized 1000 shares issued X owns 100 shares = 10% interest in corp.

1. Preemptive rights = If corp will be issuing new shares, an existing SH must be offered the right to purchase a proportionate # of new shares in order to maintain his % of ownership and voting control.

2. Preemptive rights exist only if specifically authorized in articles. MBCA 6.30(a).

3. PHCs don’t provide for preemptive rights.

Par Value

Traditional rule: Articles must state “par value” = minimum price at which dirs may sell share. Policy: – Assure that all SHs bought at same price. (But today, disclosure laws achieve fairness).

– Protect creditors by requiring that the total par paid to the corp (“stated capital”) was not paid out to SHs. (However, this didn’t really protect creditors cuz corps spent stated capital in business operations. Also, creditors found other ways of protection).

So, MBCA no longer requires any par value.

Dividends & Stock Repurchases

Dividend = payment authorized by directors in their discretion to SHs.

Stock repurchase = Another way by which SHs may receive funds from corp.

• • In CHC, potential problems: SHs may want to avoid double taxation by through payment in other way (e.g., salary, interest on loan).

Minority SHs may claim majority breaches fiduciary duty by not authorizing dividend or stock repurchase.

4. Most PHCs, pay fixed (“regular”) dividend each yr &, if has done well or has excess funds, pay “extra” or “special” dividend.

5. Legal requirements for dividend or stock repurchase: No distribution may be made if, afterwards: a. Corp would be unable to pay its debts as they become due; or b. Corp’s assets < liabilities + amount payable to senior preferred shares upon liquidation.

6. Policy: Avoid adverse impact on creditors & senior preferred SHs.

§ 4.05 Valuation

• Businesses need to be valuated in many contexts: – By creditors who decide how much to lend & measure risk of loss.

– By investors who decide price for buying or selling shares.

– By cts in various contexts, such as when SHs oppose a merger.

Liquidation

1. Liquidation value = (value of assets at liquidation sale) – (liabilities).

2. Good way to appraise value if buyer wants to divide up & liquidate assets. 3. Limitation of this method: Not good if buyer wants to keep assets together to keep bus going because part of value of such bus is its “goodwill.” Goodwill can come from a happy workforce, customer loyalty, a good location, and so on.

Book Value

1. Book Value =

equity

(amount paid for shares + retained earnings) = (

assets

) – (

liabilities

) as shown on the business’ balance sheet.

2. Balance sheet captures book value on one day, usually last day of corp’s fiscal year.

Limitations of Book Value Approach: 1. Cost-Based Accounting Rules Don’t Show Appreciation: Under GAAP, appreciation in value of assets can’t be shown (to protect creditors & securities buyers from possible overvaluation by corp).

2. Depreciation May Value Assets Below True Market Value: a. “Depreciation” = An

expense

recorded to reduce the value of a long-term tangible asset.

b. Each year’s depreciation = (cost - value at end of useful life of asset)/(# of years in useful life of asset) c. E.g. ($90,000 building – 0 value at end of useful life) / (30 yrs) = $3000 depreciation each year. So, after 10 years use, the building’s value has depreciated to $60,000.

3. Intangible Assets Undervalued on Balance Sheet: – Intangible assets include trade name, patents, TMs – Cost of developing them can be included as an asset but not market value.

Earnings Approach

1. Earnings approach focuses on estimating the present value of the business’ potential future earnings.

2. A business’ present value is less than its total future earnings because of: a. Inflation b. Risk of loss c. Opportunity cost

Formula

PV (Present value) = (A) Annual return (R) Rate R = rate of return you would estimate you would demand from the investment in an average year, given inflation, risk of loss, and opportunity costs.

Assumes annual return continues forever.

Window Washing Business Example

PV = A ($100,000) = $500,000 R (20%) Note: If you demand a higher rate of return from the investment (e.g., 25%) in an average year because you foresee higher inflation, bigger risk, or bigger opportunity costs, then the PV will be lower (here, $400,000).

Using Cash Flow to Estimate A (Annual Return or Earnings)

To estimate a corp’s future earnings, you could simply look at prior years’ income statements, but that shows depreciation, which is not a real expense.

For greater accuracy, investors look to actual cash flow reports. E.g., instead of deducting $3000 for depreciation, cash flow statements may show that just $1000 was spent to repair the building, resulting in $2,000 more in earnings. This is more accurate because the $2000 could actually be paid out to SHs.

Determining the R (Rate)

R = rate of return you would estimate you would demand from the investment in an average year, given inflation, risk of loss, and opportunity costs.

U.S. treasury bonds are considered risk-free (i.e., U.S. gov’t unlikely to default). So rate of return for U.S. treasury bonds compensates for inflation and opportunity costs. Currently, 30 year U.S. treasury bonds pay 5% interest.

For valuation of a business, the R should always be higher than risk-free U.S. treasury bonds to compensate for the risk.

4. To determine the R, look at the rate of return for similar businesses. R = A/PV, which is the inverse of the “price/earnings ratio” published by the stock markets for each PHC.

P/E for MSFT = 22.41, so R=1/22.41=4.5% (approximately)

Class 6—The Legal Model of Corp Governance—SHS Role--§5.05

A. Right to Vote B. Proxy Voting C. Proxy Fight D. SH Democracy E. Vote Buying F. Right of Expression G. Right to Information

Bd SHs elect Bd at annual meeting & monitor Bd SHs SHs monitor Ofcrs Bd selects Ofcrs, sets policies, monitors Ofcrs.

Ofcrs run Corp

A. Right to Vote

What can SHs vote on?

Elect & remove officers.

Approve bd-initiated transactions: a.

Fundamental corp changes (merger, sale of substantially all assets, voluntary dissolution) Conflicting interest transactions Amend articles 3.

SH initiated changes: a.

Amend bylaws b.

Nonbinding recommendations

When do SHs have a chance to vote?

1. Annual meetings 2. Special meetings—may be called by bd, president if authorized in articles or byles, or SHs holding 10% of voting shares.

3. Written consent of SHs instead of meeting: 1. MBCA 7.04: Consent must be unanimous.

2. DGCL 228: Same % of votes that would be necessary at a meeting.

• • Who votes?

Norm in PHCs is to have once class of common shares with 1 vote/share.

Articles may create multiple classes of shares with different voting rights. E.g: – Preferred shares may vote for dirs if fail to receive dividends – A class of shares held by founders may have multiple votes/share.

1. To hold a vote, there must be a “quorum.” 2. What % is required to win vote?

a. For bd-initiated transactions, winner is “simple majority” of votes.

b. For dirs, winner is person with “plurality” of votes.

c. Corp can set bylaws to require super majorities for certain actions.

Exercise 1

Graphic Designs is PHC incorporated in an MBCA jurisdiction. Shirley is the majority SH. The company president is Buck. Shirley offers her friend, Jenny, a highly qualified commercial artist, a job.

a. If Jenny accepts the offer, is the corporation bound under the agreement?

b. Shirley, as majority shareholder, instructs the board and Buck to hire Jenny, but they refuse. How can Shirley force the board or Buck to follow her instructions?

Exercise 2

Graphic Designs’ 5-person board authorizes Buck to fire all of the corp’s commercial artists & replace them with a computer that generates graphic designs. Shirley is upset about the board’s action.

a. As majority SH, Shirley signs & submits a written consent that purports to remove all the directors. Will this work?

b. She calls a special SH meeting to remove the incumbent dirs & Buck. Will this work?

c. She calls a SH meeting to vote on a SHs resolution requiring the board to reverse its decision. Will this work?

Voting for Dirs: Straight v. Cumulative

• • Straight voting: For each slot, each SH votes his # of shares. E.g.: • 6 dirs being elected; A owns 80 shares; B owns 20 shares. • In the election for each slot, A will win 80 to 20.

Default is straight voting, but articles can provide for cumulative voting. MBCA 7.28.

• • • • • Cumulative Voting: SH votes (his # of shares) x (# of slots), dividing votes up as he pleases. All dirs elected at once. Policy: Increase minority representation on board.

E.g.: Same scenario--6 dirs being elected; A owns 80 shares; B owns 20 shares. (So, A gets 480 votes, B gets 120 votes).

# of shares needed to elect 1 dir

(total # of shares voting) / (# of slots +1). Here, need 15 shares (100/7 = 14.28) or 90 votes (15 shares x 6 slots) to elect 1 dir.

To max results, A & B should each vote 90 shares for as many candidates as they can.

A’s 480 votes Albert Arthur Alan Amy Adam Ally Cumulative Voting: Maximizing Impact of Votes (6 slots. A 80 shares. B 20 shares.) 90 90 90 90 90 30 B’s 120 votes Beatrice 90 Benjamin Barney 30 0

Cumulative Voting: X wastes his votes.

6 slots. X has 55 shares. Y has 45 shares.

(Formula still says 90 votes to elect 1 dir).

X’s 360 votes Albert Arthur Alan Amy Adam Ally 91 90 90 89 0 0 Y’s 240 votes Beatrice 90 Benjamin 90 Barney 60

Ways to undercut cumulative voting: 1. If majority of shares can remove dir w/out cause.

2. “Stagger” bd so fewer dirs selected at once. E.g.: – 3 slots. As before, A 80 shares. B 20 shares.

– To elect 1 dir, need 26 shares [> (100 shares)/ (3 slots +1)]. So B elects no directors.

B. Proxy Voting

• A SH may vote his shares in person or by proxy (another person appointed by him to vote his shares).

• To solicit proxies, management or insurgents send to SHs a package including a proxy card, a proxy disclosure document, and a return envelope. (Some corps allow proxy voting on Internet).

• Proxy fights where both management & opposition solicit proxies on the same issue.

1. Proxy Fight to Change Dirs

1. If corp poorly run, outside group could initiate a proxy fight to replace the dirs.

2. Proxy Fight to Facilitate an Acquisition

1. If someone wants to acquire a corp but incumbent dirs are opposed, there may be a proxy fight to replace them with dirs in favor of acquisition.

2. If the matter is not one where SHs have a right to vote, then the proposal can instead include a recommendation to the bd.

3. Proxy Fight to Change Corp Policy

1. If insurgents want to change corp policy, they may, under SEC Rule 14a-8, include their proposal with management’s proxy request (on the same proxy card).

Collective Action Problem

1. Proxy fights often fail due to “collective action problem.” 2. Why is collective action hard? SHs diverse investment portfolios so pay little attention to single corp; SHs dispersed so not easy to organize.

3. Is this “rational apathy”?

– Cost of bad management may be less than cost of proxy fight to fix it.

– “Free ride” problem.

– “Wall Street rule.”

1. Collective action is easier for institutional SHs because benefits of proxy battle may outweigh costs: • • Much larger stake in corp.

Hard to exercise “Wall Street rule” because selling a large block of shares would depress share price.

• Possible to organize through firms like Institutional Shareholder Services and Investors Responsibility Research Center that research proxy issues & give vote recommendations.

Interesting Proxy Battles

• • •

Company: Chevron

When:

April 26, 2006

Why:

A binding proposal by

Harvard University

law professor Lucian Bebchuk seeks to reimburse shareholder proponents for the reasonable expenses of filing proposals that receive majority support, including expenses related to opposing the company's attempt to exclude the proposal. The reimbursement would not exceed the company's expenses related to seeking to omit that proposal.

• • •

Company: IBM

When:

April 25, 2006

Why:

IBM & its suppliers’ business practices in China should respect human and labor rights of workers by adopting a set of principles defined by the Int’l Labor Organization (e.g., no products shall be manufactured in prison camps, must comply with China’s wage and hour guidelines). Management opposes this proposal, arguing that IBM is already a CSR leader.

Class 7—The Legal Model of Corp Governance

SH Role (cont’d) D. SH Democracy E. Vote Buying F. Right of Expression G. Right to Information Board of Directors Officers Exam

D. SH Democracy

1. Issue: What if bd tries to thwart SH vote during a proxy fight or a “hostile tender offer”? How closely will ct “scrutinize” bd’s action (i.e., what “standard of review” is appropriate)?

Schnell (Del. 1971) (p.116) F: Bd, fearing proxy challenge that had begun to organize, moved up date of annual meeting, making challenge more difficult. Bylaws gave bd power to change meeting date.

H: Original meeting date reinstated because purpose of change was to interfere with SH voting (corp democracy).

Blasius Industries (Del. Ch. 1988) (p.116) F: – – SH written consent vote to expand bd from 7-15. Goal was to recapitalize (p.116, n.142).

Incumbent bd responds by expanding bd by 2 more seats to keep majority. Goal was to defeat recapitalization.

H: Purpose of bd action was to interfere with SH voting. In such cases, standard of review is that bd must have a “compelling justification.” R: Ct rejected argument that standard should be “business judgment rule.”

Stroud (Del. 1992) (p.117) F: – Bd votes to amend arts to create new qualifications for dirs. (Purpose was to protect incumbents).

– Fully informed SHs voted to approve this amendment.

H: Ct held that “compelling justification” standard inappropriate, even though amendment would interfere with SH voting in future, because fully informed SHs voted in favor of it.

Williams (Del. 1996) (p.117) F: – Recapitalization plan includes “tenure voting”: shares will be super-voting (10 votes/share) but if transferred, only 1 vote/share for first 3 yrs.

– Plan approved by SH vote.

H: Business judgment rule will be applied.

E. Vote Buying

Vote buying = SH given extra benefit for voting particular way.

Early cts held illegal per se, but today just view with suspicion.

Schreiber v. Carney

(Del. 1982) (Pinto p.119, n.160): Large SH opposed corp reorganization because of personal tax liabilities. Corp “bought” SH’s vote by agreeing to loan SH $ to avoid the tax liability. Here, vote buying was not illegal because its purpose was to benefit the SHs by allowing reorganization, not to defraud SHs.

1. Coercion = SH threatened with harm to his interest unless votes particular way.

2. Lacos Land Co. v. Arden Group Inc.

(Del. Ch. 1986) (Pinto 254, n.8): CEO/Dir threatened to block future beneficial corp transactions unless SHs approved restructuring giving him super-voting shares. Held: Restructuring enjoined because vote coerced.

3. Evaluation: Coercion like vote buying may be tolerated by ct but only if purpose is to benefit corp, not to defraud SHs.

F. Right to Expression

1. SHs have right to express views to dirs.

2. Auer v. Dressel

(N.Y. 1954) (Pinto 120): SHs called for special meeting to endorse former president who had been removed by dirs. Management refused to hold special meeting on ground that only dirs have power to choose officers. Held: SHs have right to express views to board.

G. Right to Information

1. Annual financial statements (MBCA 16.20): Must include year-end balance sheet, income statement, statement of changes in SH equity. Must be audited by CPA or prepared based on GAAP or explain deviations from GAAP.

What is an income (aka profit & loss) statement?

• Shows net income = income – expenses.

• Indicates performance of business over that period, pinpointing unexpected increases in expenditures.

• Use income statement to figure business tax.

Beta Sales Company Income Statement For the Year Ended December 31, 200X Sales

Cost of Goods Sold

Beginning Inventory Add: Purchases Total: Less: Ending Inventory Cost of Goods Sold Gross Profit $27,335 235,689 263,024 32,090 $462,452 230,934 231,518

Expenses Advertising Depreciation Insurance Payroll taxes Rent Repairs & Maintenance Utilities Wages Total Expenses

NET INCOME

1,850 13,250 5,400 8,200 9,600 13,984 17,801 98,852 168,937

$62,581

2. Annual Report for SOS (MBCA 16.22): Must state agent for service of process, # of shares authorized & issued, etc.

3. SEC reporting requirements for stocks registered on national securities exchange (3300 corps) & to corps traded OTC if 500 SHs & $10 million assets (13,000 corps): 1. Annual 10-K (prepared by independent CPA firm) 2. Quarterly 10-Q (unaudited financial results) 3. Near real-time 8-K (e.g., change in control, resignation of director)

4. SH Right to Inspect Books & Records or List of SHs (MBCA 16.02): a. SH can on 5 days notice inspect & copy records like minutes of SH meetings, articles, bylaws, list of current dirs.

b. SH must have “proper purpose” to inspect & copy minutes of dir meetings, accounting records, SH list.

– E.g., need SH list to communicate w/SHs or request proxies.

– E.g., need to inspect accounting records to find wrongdoing, assist SH litigation, appraise shares.

c. What is a proper purpose?

Security First Corp.

(Del. 1997) (Pinto p.121, n.169): To et access to accounting records, SH must show credible basis of probable wrongdoing.

ii. Pillsbury v. Honeywell

(Minn. 1971) (Pinto p.122)

iii. Conservative Caucus v. Chevron

(Del. Ch. 1987) (Pinto p.122, n.175) iv. Policy: balance SH right to info w/possible harassment of mgt & misuse of info.

§5.06 Board of Directors

1. Legal model seeks to balance: – Allow SHs to monitor Bd to limit self-dealing & mismanagement.

– Allow Bd flexibility to mng corp as they see fit w/out too much SH interference.

2. Dirs are fiduciaries of corp but not agents of SHs.

Board Structure

Unitary board # of dirs set out in articles or bylaws Dirs serve 1-yr term unless staggered bd, in which case may serve up to 3 yrs. In PHCs, majority of dirs must be independent. Bd may establish committees, which make recommendations to bd & w/in limits act for bd.

PHCs must have some committees made up entirely of independent dirs: audit, compensation, nominating.

Meetings

1. Voting: a. Majority presence at meeting required for quorum; majority of those present required to act. (Default rules).

b. As discussed, some bd-initiated actions require SH vote for approval.

2. Equivalent to meeting: a. Unanimous written consent of directors b. Teleconference.

1. Action w/out meeting or equivalent:

a. Baldwin v. Canfield

p.125) (Minn. 1879) (Pinto b. Modern view looks at substance over form.

2. In

Baldwin

, what should 3P have done to ensure bd action transferring land to him followed proper formalities?

– Get copy of bd resolution from meeting “minutes” with corp secretary’s certificate of authenticity & accuracy.

§5.07 Officers

1. Appointed by dirs to conduct corp’s daily operations.

2. Officer may be removed by bd at will w/out cause.

1. Bylaws may specify corp officers & their duties.

2. Typical officers: a. President: Overall responsibility for corp mgt. Directly responsible for carrying out bd’s orders.

b. VPs: Assist President in specified ways.

c. Treasurer: CFO responsible for controlling & recording its finances & maintaining corporate bank accounts.

d. Secretary: Responsible for maintaining the corporate records.

Officers are Agents of Corp 1.

Agent = Person authorized to act for principal.

Three types of authority (making principal responsible for agent’s actions): Express authority: Principal expressly authorizes agent to act. E.g., authorization in bylaws, bd resolutions, employment k. E.g., store owner says to manager, “go buy some goods.” Implied authority: Principal implicitly authorizes agent to act. E.g., store manager may purchase goods even if not expressly told to do so. Authority is implied by store owner hiring him for position.

Apparent authority: Principal’s action manifests to 3P that agent has authority, 3P relies. E.g., store owner hires manager but says “don’t buy anything” (so no express or implied authority. Manager buys anyway. 3P can claim owner liable under apparent authority—Action manifesting authority was hiring with title of “manager”; 3P relied by selling goods.

Exam

• Multiple Choice: Choose single best choice.

• Short Answer • Essay

Sample Multiple Choice

Jackson, a famous and wealthy singer, has patented a portable recording device, which he wants to manufacture and sell. If he chooses to do business under a sole proprietorship structure, which of the following statements best describes Jackson’s personal liability to contract creditors of the proprietorship?

(a) Jackson has no personal liability to proprietorship contract creditors.

(b) Jackson is personally liable to the proprietorship’s contract creditors.

he had personally guaranteed their obligations.

(d) None of the above.

MISC

Cumulative Voting: Impact of Staggered Board:

A’s candidates (total 80x3=240 votes) Albert 75 Arthur Alan 75 90 B’s candidates (total 20x3=60 votes) Beatrice 60 Benjamin Barney 0 0

Statutory Merger

A Inc.

consideration B’s shares B Inc.

B merges into A. A survives. B dissolves.

Consolidation

A Inc.

C Inc.

B Inc.

A&B merge into C, a new corp. A&B dissolve.

A Inc.

Forward Triangular Merger

B Inc.

A s Inc.

A creates A s (a wholly owned subsidiary), capitalizing A s with A shares.

B merges into A s , so A s now holds B’s shares. Result is that A indirectly controls B.

A Inc.

Reverse Triangular Merger

B Inc.

A s Inc.

A creates A s (a wholly owned subsidiary). A exchanges 100,000 A shares for all of A s shares.

A s merges into B: All B’s shares exchanged for the 100,000 A shares held by A s .

A s disappears--its assets (ie, all of B shares) are transferred to A. A is now B’s parent corp because it owns all of B’s shares.

Voting Rights Merger Triangular Merger

A Inc

Yes* Yes* Sale of Assets Yes* * Pursuant to 20% Rule

MBCA B Inc

Yes Yes Yes

A Inc

Yes No No

DE B Inc

Yes Yes Yes Appraisal Rights

MBCA

Merger Triangular Merger

A Inc

No No

B Inc

Yes Yes

A Inc

Yes No

Sale of Assets No Yes No Note: No appraisal rights if market exception (discussed below) applies.

B Inc

Yes Yes No

UNITED STATES SECURITIES AND EXCHANGE COMMISSION FORM 8-K Date of Report: March 30, 2005 STARBUCKS CORPORATION … Item 5.02 Departure of Directors or Principal Officers; Election of Directors; Appointment of Principal Officers.

Effective as of March 31, 2005, Orin C. Smith retired as president and chief executive officer of the Company and from the Company’s Board of Directors. Effective as of April 1, 2005, James L. Donald, 51, was appointed president and chief executive officer of the Company and was appointed to the Company’s Board of Directors as a Class 2 director.…

Base Pay

…$840,000…

Bonus

Mr. Donald will continue to be eligible to participate in the Company’s Executive Management Bonus Plan at an incentive target of 100% of his eligible base salary…. The objective performance criteria for such incentive targets have been established for him by the independent members of the Company’s Board of Directors.

Stock Options

…Mr. Donald was granted 100,000 non-qualified stock options at a per share exercise price equal to the regular trading session closing price of a share of the Company’s common stock on April 1, 2005. The stock options vest in three equal annual installments and expire on April 1, 2015, subject to Mr. Donald’s continued employment.

Microsoft (MSFT) Apr. 4, 2005 Source: Thompson Financial

Due Diligence Defense

Expertised portion Nonexpertised portion Expert Nonexpert

Must reasonably investigate & reasonably believe info is true Must not believe info is false No liability Must reasonably investigate and reasonably believe info is true

Regulation D Hypothetical

Outdoor Café Inc. plans to open new restaurants throughout New England. They will need about $3 million, which they can raise by selling 300,000 new shares at $10 to personal acquaintances and a group of venture capitalists. Can Outdoor Café fit within the Regulation D exemption if it has the following investors?

•10 with net worth over $1 million •10 with incomes over $200,000 •10 intimately familiar with the restaurant business •10 relatives of the CEO

SEC Rule 14a-9 (Proxy Fraud) No proxy solicitation shall be made, written or oral containing any false or misleading statement of material fact or omission of material fact necessary in order to make the statements therein not false or misleading in light of the circumstances at the time

Elements of Common Law Fraud: Elements of SEC Rule 14a-9: Materiality:

A reasonable man would attach importance to the statement in determining his course of action.

Falsity:

General rule that omissions not actionable. Opinions often not actionable

State of mind:

Knowledge or intent to deceive or at least reckless disregard of the truth Substantial likelihood that a reasonable investor would consider statement an important factor in deciding how to vote Omissions and opinions may be actionable more often.

Negligence

Justifiable reliance Loss causation

No separate requirement Proxy solicitation was an essential link in accomplishing the transaction OR the misrepresentation led investors to forego state law remedies

PROXY STATEMENT FOR ANNUAL MEETING OF SHAREHOLDERS TO BE HELD NOVEMBER 9, 2004 This Proxy Statement … is furnished in connection with the solicitation of proxies by the Board of Directors … to be voted at the annual meeting of the shareholders … on November 9, 2004…. The Company will pay the cost of solicitation of proxies….

ELECTION OF DIRECTORS AND MANAGEMENT INFORMATION Nine directors are to be elected at the annual meeting to hold office until the next annual meeting of shareholders…. The election of the Company’s directors requires a plurality of the votes cast….

NOMINEES

William H. Gates III, 48, as a co-founder of the Company, has served as Chairman since the Company’s incorporation in 1981. Mr. Gates served as the Company’s Chief Executive Officer from 1981 until January 2000, when he resigned as Chief Executive Officer and assumed the position of Chief Software Architect. Mr. Gates is also a director of ICOS Corporation….

Steven A. Ballmer, 48, has headed several Microsoft divisions during the past 20 years, including operations, operating systems development, and sales and support. In July 1998, he was promoted to president, a role that gave him day-to-day responsibility for running Microsoft. He was named Chief Executive Officer in January 2000, assuming full management responsibility for the Company. Mr. Ballmer is also a director of Accenture Ltd….

INFORMATION REGARDING BENEFICIAL OWNERSHIP

The following table sets forth, as of September 10, 2004, information regarding the beneficial ownership of the Company’s common shares by all directors…

Names Amount and Nature of Beneficial Ownership of Common Shares as of 9/10/2004 (1) Percent of Class

William H. Gates III 1,097,499,336 (2)(3) 10.09% Steven A. Ballmer 410,967,990 3.78%

INFORMATION REGARDING EXECUTIVE OFFICER COMPENSATION

The following table discloses compensation received for the three fiscal years ended June 30, 2004 by the Named Executive Officers.

Annual Compensation Name and Principal Position

Steven A. Ballmer William H. Gates III

Salary

$ 591, 667 591,6 67

Bonus

$310,000 310,000

Long-Term Compensation Awards Restricted Stock Award(s) ($)

–

Securities Underlying Options (#)

– – –

All Other Compens ation

$7,865 1,715

May 11, 2005

Duty of Care & Business Judgment Rule

Topics: • Introduction • Policy Issues • Duty of Care • Overcoming the Business Judgment Rule • Demise of the Duty of Care

Introduction • Q: What is a fiduciary duty?

• A: A duty to act primarily for another

’

s benefit in connection with a particular undertaking

Introduction (cont

’

d)

In what contexts do fiduciary duties arise in corp law? E.g.: 1. Duty of care of Ds 2. Duty of loyalty of D&Os 3. Executive compensation 4. Fiduciary duties of controlling SHs

Introduction (cont

’

d)

Q: How are fiduciary duties enforced?

A: Through derivative suits brought by SHs in the name of the corp. • Each D who voted for the action (or, in non-vote situation, failed to object) is “ jointly and severally liable ” for damages.

• Ct can enjoin or rescind Board action.

Policy Issues

The separation of roles — SH investment & D management — creates tension: Management Discretion Management Accountability

Duty of Care

• Source of Law: – originally CL, but now some state statutes. MBCA § 8.30 is typical.

• Elements: – Duty – Breach – Proximate cause – Loss

Duty of Care — Duty Element

Ds must act: • In good faith; • In manner reasonably believed to be in corp ’ s best interest; & • With care that a person in like position would reasonably believe appropriate under similar circumstances.

(MBCA § 8.30)

Duty of Care — Breach Element — Business Judgment Rule

• Accusations of breach are subject to review under the business judgment rule, under which Ct will presume there was no breach.

• This rule limits judicial inquiry into Board decisions.

Duty of Care — Overcoming Business Judgment Rule

Business judgment rule not applicable (or can be overcome) where: • Lack of good faith (fraud, illegality, or conflict of interest) • Waste • Gross negligence in procedure • Oversight failure--Inattention